Nearly two years after issuing the proposed rule, the U.S. Securities and Exchange Commission (SEC) on August 5, 2015, adopted by a 3-2 vote, the final rule on CEO‑to‑median employee pay ratio disclosure in what has become known as the “Pay Ratio Rule.”

The Pay Ratio Rule was first proposed by the SEC on September 18, 2013, under the Congressional mandate contained in Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). Section 953(b) directed the SEC to amend its executive compensation disclosure rules under Item 402 of Regulation S-K to require public companies to disclose the median of the annual total compensation of all employees, excluding the CEO, the annual total compensation of the CEO, and the ratio of the median employee annual total compensation to the annual total compensation of the CEO. Since publication of the proposed rule, the SEC received more than 287,000 comment letters, including more than 1,500 unique letters, from a wide variety of individuals, industry groups, law firms, professional organizations and businesses of all sizes throughout the United States and the world.

Principal Changes in the Final Rule

The principal changes made to the Pay Ratio Rule appear to be designed to decrease the overall compliance costs associated with the Pay Ratio Rule while remaining consistent with the Section 953(b) Congressional mandate. Those changes include:

• Inclusion of all Employees – While the final rule retains the requirement that all U.S., non-U.S, full-time, part-time and seasonal or temporary workers must be included, there are some notable changes in the final Pay Ratio Rule:

- the addition of a de minimis exemption of 5 percent of the registrant’s non-U.S. workforce

- the exclusion of non-U.S. employees in jurisdictions where collection and transmission of the compensation and personal data would violate applicable foreign privacy and data security laws, subject to significant requirements 

- the inclusion of only employees of the registrant and its consolidated subsidiaries

• Identification of the Median Employee – The final rule retains the flexibility provided to a registrant to determine the methodology used to identify the median employee and the median employee’s compensation. For example, a registrant may utilize:

- a methodology that uses reasonable estimates to identify the median employee, including annual total compensation or any other compensation measure that is consistently applied to all employees included in the calculation, such as information derived from tax and/or payroll records, or

- statistical sampling or other reasonable methods to determine the employees from which the median is identified

In addition, the final rule allows for:

- Use of the identified median employee for three years – A registrant may use the median employee whose compensation will be used for the annual total compensation calculation for up to three fiscal years, unless there has been a change in its employee population or employee compensation arrangements that the registrant reasonably believes would result in a significant change in the pay ratio disclosure

- More flexibility in selecting the date for determining the number of employees – Under the proposed rule, each registrant was required to use the last day of its fiscal year for determining the number of total employees. Under the final rule, the registrant can now select any date in the last fiscal quarter of each year, a change designed to provide additional flexibility for registrants

• Calculation of the Median Employee Compensation – The SEC noted that in using statistical sampling or tax and/or payroll records for collection of compensation data, the information collected might not include all compensation required under Item 402(c)(2)(x) of Regulation S-K, but recognized that such use of estimates, statistical sampling or the like could significantly reduce the compliance costs associated with the final rule. CEO compensation will continue to be calculated and disclosed in accordance with Item 402 or Regulation S-K. In addition, the final rule allows a registrant to use a cost of living (COL) adjustment depending on the principal residence of its CEO. A registrant can apply a COL adjustment if it determines that a disparity exists in the cost of living between the jurisdiction of residence of its CEO and the location(s) of other employees. If such COL adjustment is used, the registrant will be required to disclose both the adjusted and the unadjusted ratio.

What Stayed the Same in the Final Rule

The final rule continues to require the pay ratio disclosure in annual reports, proxy or information statements and registrations statements where Regulation S-K Item 402 disclosure is otherwise required. Similar to other Item 402 disclosure, the final rule continues to treat the pay ratio disclosure as “filed” rather than “furnished” for purposes of liability under the federal securities laws. The final rule provides certainty as when the pay ratio needs to be recalculated–the prior fiscal year pay ratio disclosure can be used until the next annual report or proxy statement is required to be filed, i.e., within 120 days after the end of the applicable fiscal year.

The following registrants are exempt from compliance with the Pay Ratio Rule – emerging growth companies, smaller reporting companies, foreign private issuers, registered investment companies and U.S.-Canadian Multijurisdictional Disclosure System filers.

Economic Analysis

The adopting release notes that the pay ratio disclosure may be considered valuable, useful information for investors, particularly in making an assessment of say-on-pay advisory votes. However, the SEC also recognized the concerns regarding the costs of complying with the Pay Ratio Rule, both initially and annually. Many of the changes in the final rule were made to address the concern regarding the burden of the compliance costs as compared to the lack of definitive benefits that could be identified. 

Effectiveness and Transition Provisions

The final rule extends compliance for an additional year as compared to the proposed rule. Applicable registrants will need to comply with the rule in the first fiscal year commencing on or after January 1, 2017. Accordingly, for a calendar year-end company, the first year for which the pay ratio information will need to be collected will be 2017, with disclosure included in its annual report or proxy statement filed and distributed to shareholders in 2018. 

Pay ratio disclosure will not be required to be included in a registration statement on Form S‑1 or Form S-11 for an initial public offering or in a registration statement on Form 10. Instead, a new registrant will need to comply with the Pay Ratio Rule for the first fiscal year commencing on or after the date it became subject to the reporting requirements of Section 13(a) or Section 15(d) of the Securities Exchange Act of 1934. Such newly reporting registrants will not be required to include the disclosure in any filing until the Form 10-K for such fiscal year, or if later, the proxy or information statement for its annual meeting of shareholders following the end of such fiscal year.

In addition, the Pay Ratio Rule provides that a registrant that ceases to be a smaller reporting company or an emerging growth company will not be required to provide pay ratio disclosure until after its first full fiscal year after exiting such status, and not for any fiscal year commencing before January 1, 2017.

The Pay Ratio Rule also permits registrants that engage in business combinations or acquisitions to omit the employees of a newly acquired entity from the pay ratio calculation for the fiscal year in which the business combination or acquisition occurs. In these cases, a registrant does not have to include these individual employees in its median employee calculation until the first full fiscal year following the acquisition.